Large-Cap Stocks Keep the S&P 500 Afloat

Major Moves

Stock indexes are incredibly useful tools because they give us a big-picture view into what the market as a whole is doing at any moment. However, indexes can also obscure some information by averaging it out with a lot of other information.

For example, most traders like to watch the S&P 500 to get a sense for whether the stock market is currently bullish or bearish. But because of the way the S&P 500 is constructed, we aren't actually getting a view of the entire market by looking at it. We're primarily getting a view of how some of the biggest stocks on Wall Street are performing.

You see, the S&P 500 is a market-cap weighted index. That means that, the larger the market cap of the stock, the greater the impact the movement of that stock is going to have on the index.

Currently, the largest stock in the S&P 500 is Microsoft Corporation (MSFT), with a market cap of $973.39 billion. At the other end of the spectrum, the smallest stock in the index is Fossil Group, Inc. (FOSL), with a market cap of only $582.75 million. Because of this difference in size, when Microsoft makes a bit move, the S&P 500 moves a lot, but when Fossil Group makes a big move, the index barely reacts.

To combat this imbalance in impact, analysts have created an equal-weighted version of the S&P 500 that gives every stock in the index the same opportunity to affect the value of the index. You can track this index using the Invesco S&P 500 Equal Weight ETF (RSP).

So what happens when you compare the performance of the standard S&P 500 index – using the SPDR S&P 500 ETF (SPY), in this case – with the performance of the RSP in a relative strength chart? You can see whether the price movement of the standard S&P 500 is being driven primarily by the larger-cap stocks in the index or by a broad mix of stocks in the index.

If the SPY/RSP relative strength chart is moving higher, it tells you that SPY is outperforming RSP, which means large-cap stocks are driving the majority of the gains. If the SPY/RSP relative strength chart is moving lower, it tells you that RSP is outperforming SPY, which means a broad mix of stocks are driving the gains.

Looking at the SPY/RSP comparison chart below, you can see that SPY has been outperforming RSP during most of 2019. This tells me that I need to keep an eye on the largest-cap stocks in the index to see where the market is going to go next.

Risk Indicators – Margin Debt

I'm always looking for confirmation of trader sentiment on Wall Street. If I can confirm that traders are bullish, I feel more confident in my bullish outlook. Conversely, if I can confirm that traders are bearish, I feel more confident in my bearish outlook. After all, traders drive prices.

One of my favorite ways to see just how bullish traders are is to look at how much money traders are borrowing to buy the stocks they are trading. Traders can borrow up to 50% of the purchase price of a stock – according to Regulation T of the Federal Reserve Board. So if a stock costs $100, you only have to use $50 of your own money to purchase the stock. You can borrow the other $50.

Borrowing money to buy stocks is referred to as buying on margin, and the amount of money you have borrowed to buy stock is called "margin debt." Tracking the total amount of margin debt being used to buy stocks can give you a good sense of how confident traders are. Confident traders tend to borrow more. Nervous traders tend to borrow less.

Margin debt climbed to an all-time high of $668,940,000,000 in May 2018. It then began to stabilize in mid-2018. By the latter part of 2018, margin debt started to retreat, falling to 607,645,000,000 in October and then reaching its recent low of 554,285,000,000 in December 2018. Since December 2018, margin debt levels have been climbing. Margin debt has rebounded to 588,721,000,000 as of April – according to recently released data from FINRA.

FINRA releases its margin debt data a month after the fact. That's why we are just now seeing the data for April. We'll have to wait until the last week in June to see May's data. Even so, the increase in borrowing to buy stocks confirms that traders are becoming increasingly confident. This is a promising sign for the S&P 500.

A mutual fund is defined as a type of investment vehicle consisting of a portfolio of stocks, bonds or other securities, which is overseen by a professional money manager. Long a favored choice for retail investors, mutual funds have both advantages and disadvantages compared to other asset classes.

Breadth indicators are mathematical formulas that measure the number of advancing and declining stocks, or their volume, to calculate the amount of participation in a market movement. They are used to confirm trends or warn of reversals.